Hedge Fund Fees: A Primer

Most hedge funds usually have the same type of fee structure. First you have the "management fee", and then you have the "performance fee."

The management fee is taken regardless of the performance of the hedge fund. This fee is used to pay salaries, rent and other assorted fixed costs. Most hedge funds will charge somewhere in the neighborhood of 2-3% for their annual management fee. This means that if there is a billion dollars under management, then the hedge fund company will receive $20 million dollars as their management fee. Obviously, the more capital under management, the more money the hedge fund will make for their management fee.

The "performance fee", on the other hand, is exactly as it sounds - a fee that is paid out based on the performance of the fund. Most hedge funds will have a "2 and 20" fee structure - this means that 2% is taken as a management fee, and 20% is taken as a performance fee. The performance fee is only taken if the hedge fund makes a profit, and it only applies to the profits that the fund generates. So, if the billion dollar hedge fund generates $200 million dollars in profits during the calendar year, then a fund with a 20% performance fee would rake in $40 million dollars.

The well-established and ultra-successful hedge funds will charge higher performance fees, as well as sometimes charging higher management fees. Some very well-known hedge funds (SAC Capital and others) will charge 40-50% as their performance fee. They can get away with this because they are so successful year-in and year-out, and people are literally begging to invest money in their funds. It's an easy sell.

If you ever wondered how some hedge fund managers could make a billion dollars plus in one year - look no further than the performance fee. The management fee goes towards paying salaries, rent and other expenses, but the performance fee goes mostly to the managers of the funds. So, if a $10 billion dollar hedge fund has a 20% return in one year, then the fund would generate anywhere from $2-$4 billion dollars in performance fees, depending on the structure of the fund. So in this scenario, a manager of the fund could easily bank over a billion dollars for himself personally. This structure is why there was such a hedge fund frenzy a few years back - many people saw the operation of a hedge fund as their ticket to riches.

Don't expect this fee structure to change anytime soon, even with many hedge funds struggling. The setup is simply too lucrative for the managers of the funds.